One might object to this theory by pointing out that the housing bubble created an oversupply of houses, so supply restrictions couldn't have caused the housing bubble. However, this objection confuses cause and effect: the effect of the housing bubble has been to create an oversupply of housing, but that says nothing about the cause. (Also, supply restrictions aren't static.) So how can supply restrictions lead to a housing bubble that creates an oversupply of housing?
It's because housing, like tax cuts, can be peddled as great in any situation. As Paul Krugman has noted, tax cuts can be peddled as the solution to every problem:
So too with housing. Realtors can peddle housing as a great buy in any situation. If housing prices are rising, then housing is a great investment. Once the value of your house appreciates, you can refinance or sell, and voilà — free money! If housing prices are falling, then hurry up and buy a house while they're cheap!If the economy is growing ... then it shows that past tax cuts achieved wonders — so let’s cut taxes some more!
If the economy is shrinking, well, it needs a boost — and what better boost than another round of tax cuts!
This can lead to a housing bubble through a 2-step process. First, low interest rates drives down mortgage interest rates — so buy a house now while they're cheap! Second, the suddenly lower mortgage rates leads to a demand shock. As I've noted in a previous post, a demand shock leads to a (very) long period of housing price appreciation — so housing is a great investment!
Where do land use regulations fit in? They facilitate the transition from "buy housing while it's cheap" to "housing is a great investment." Empirical research has shown that a demand shock in metropolitan areas with more restrictive land use regulations leads to much higher and much longer housing price appreciation, as the following graph shows (Houston = least restrictive; Tucson = medium restrictiveness; San Jose = most restrictive):2
The length of the housing price appreciation (6 years in the above graph) assures people of the stability of the upward trend. In other words, as I've argued before, 6 years of rising housing prices gives realtors and homebuyers the impression that "housing prices always go up!"This is where "housing as a great investment" takes over. As the recent paper by Dusansky and Koc (2007) that I highlighted before shows:
"We find that an increase in housing prices increases the demand for owner-occupied housing services. Thus, housing's role as investment asset with its potential for capital gains dominates its role as consumption good, which alone would produce a downward sloping own demand curve rather than one which is upward sloping."
In sum, in an area with restrictive land use regulations, a sudden increase in demand for housing leads to a lengthy housing price appreciation, which then increases the demand for housing (as an investment). Moreover, as "housing as a great investment" takes over for "buy a house while they're cheap," the buyers are more likely to be speculators, who obviously accelerate asset bubbles.
I'm not arguing that restrictive land use regulations were the sole cause of the housing bubble; there were obviously a multitude of factors at play. I'm simply arguing that the effect that land use regulations has on the housing market was one of the most important factors -- and certainly the most overlooked factor.
1 Denise DiPasquale & Edward L. Glaeser, Incentives and Social Capital: Are Homeowners Better Citizens?, 45(2) Journal of Urban Economics 354-384 (1999).
2 Min Hwang & John M. Quigley, Economic Fundamentals in Local Housing Markets: Evidence from U.S. Metropolitan Regions, 46(3) Journal of Regional Science 425-453 (2006).
Posts
